Dr. Katherine Hunt: [00:00] Other research that I do on the financial inclusion side has found that small and micro enterprises are the most efficient users of capital, so they can take any amount, like any tiny amount of debt and turn it into huge returns, 1000s of percent and that’s common across small and micro businesses. That is what they do, they use capital most efficiently in our economy.
Fraser Jack: [00:26] Hell, and welcome to the Goals Based Advice podcast where I have conversations with pioneers of the new world of financial advice. I’m your host Fraser Jack, I want to thank you so much for tuning in today. I’d also like to thank our supporting partner; Advice Intelligence, for powering this podcast. In this episode I chat with a Dr Katherine Hunt who has recently published a research paper around gearing and in particular; is it work the risks?
Fraser Jack: [00:52] I was fascinated with the outcomes of the research and figured that you would be too. Katherine shares with us what the research covers, the rigorous process that they followed to come up with the conclusions and a heat map of when were the best months to invest, looking backwards of course. The outcomes and stats on the research shocked me and I believe should be part of the gearing and investment conversation and worth reading and understanding if you’re providing investment advice. It’s a short episode as we just stick to the one point, but let’s kick off my chat with Katherine now.
Fraser Jack: [01:35] Welcome back to the show, Katherine.
Dr. Katherine Hunt: [01:37] Thank you, Fraser.
Fraser Jack: [01:39] It’s a pleasure to have you back on the show, second appearance which is great.
Dr. Katherine Hunt: [01:43] Absolutely, best podcast in the world, I wouldn’t miss it.
Fraser Jack: [01:48] So today I thought we’d get you back because you and I were chatting the other day and you mentioned something that I thought was going to be really interesting, for the listeners of this show anyway, that some research you’re doing. Do you want to us a quick overview of that?
Dr. Katherine Hunt: [02:04] Absolutely. The area of this research is gearing, geared investment strategies, most financial advisors will be familiar with it. Not only do they study it at university but it’s been a common, common but decreasing strategy, I should say, in the financial services sector. And so Professor Brimble, Professor Mark Brimble, and I wanted to figure out; is it worth doing as a strategy? Just quantitatively if we look at, if we make up a summary of all the parameters; is it actually a strategy that’s worth doing or worth recommending for financial advisors, for example, or worth doing for retail investors?
Fraser Jack: [02:47] Yeah, good question, good question. Because we’re talking about a financial strategy we probably should throw in a general advice warning or a general strategic or strategy information warning. I would imagine we should do that, it’s not personal advice, do you want to?
Dr. Katherine Hunt: [03:05] Absolutely. It’s definitely not personal advice, so what we’re going to talk about is some research that we’ve done which means that it’s looking at the results of this strategy based on certain parameters that are definitely not your parameters. The results of this research can’t actually be applied to any individual person, it’s more for financial advisors to really pick up these findings and then apply it to their clients.
Fraser Jack: [03:32] Perfect, perfect. All right, so you’ve come up with a question, is it worth it, then what do you do? How do you go about setting up a research paper, from an academic point of view and all that sort of stuff? Want to walk us through that process?
Dr. Katherine Hunt: [03:45] From an academic point of view it’s all just a very big job. We always start off with everything we do with a huge literature review of all the work that’s come before us. It’s kind of strange, but we don’t actually really do anything new, we do stuff that’s just a little bit different to what’s been done before, we try and walk on the shoulders of giants, or stand on the shoulders of giants. Walk on them, that would be funny, well maybe if they’re all lined up.
Dr. Katherine Hunt: [04:15] The way we do this; we figure out what are the key issues here, what are we really playing with and what does the literature say that’s actually come before us. So in this particular field there’s a couple of issues that we know about which is, first off, there’s the lifecycle investment approach. Which means as people get older we shift, simply because of their age, more of their assets to defensive classes like cash, for example, fixed interest, more stable or at least protecting the capital side in theory. This approach is also very intriguing given that people are, say, retiring at age 65 there but they’ve got a life expectancy of 85 so we do have a 20 year investment horizon. It’s very kind of weird that we’re shifting people into those just based on their age rather than considering their investment horizon at that point.
Dr. Katherine Hunt: [05:06] What this means though is that a lot of people in either default funds or even if they’re seeing a financial advisor as well it could happen, or if they make choices by themselves, they are shifting to more conservative assets at the point of retirement. Or before retirement even, which introduces something that we call Sequencing Risk, which is the risk that you are selling out of your growth assets at just a time that suits you, rather than a time that is wise.
Dr. Katherine Hunt: [05:35] So it’s all really about this Sequencing Risk and that’s what the literature before us really said. This Sequencing Risk, we can map out when Sequencing Risk is really a problem and we wanted to make sure that we covered that in the .... this particular research. What we did is we modeled every possible portfolio, meaning 413 portfolios starting from 1976 going all the way up until finishing in July 2017 when this paper was finalized. And that means investments happening every single month, last and ... There’s a lot of parameters around each of these geared portfolios. Shall I run through some of the detail of the parameters that we were looking at?
Fraser Jack: [06:24] Yeah, yeah, do that, it’d be good.
Dr. Katherine Hunt: [06:25] Great. So for each of these 413 geared portfolios what we did is, of course, we talked to our experts in the industry who know about these details so we developed the parameters such as; each investment was in the ASX All Ordinaries, for five years, it was a total of $100,000 capital investment and $100,000 geared, so 50:50 ratio, using a one month forward roll. Then we calculated everything at the end of ... based on end of month data, interest rates and fees and what not. And we assumed things like all the returns were reinvested and for example that margin calls were tracked but not initiated and there’s no Insure Exit fees, but we had a $500 per year lending fee and a $10 per month for example, 1.5% MER, management expense ratio, and the interest rate was set to whatever the RBA rate was for that month and that was calculated monthly as well based on the RBA and then based on the balance.
Dr. Katherine Hunt: [07:33] This really is underscored by a passive investment approach and we know there’s a huge other body of literature on passive versus active investing and we do know that it is quite difficult for people to predict what the market is going to be doing in the future in a general sense and so that’s why this portfolio is set up to be passive. You’ve got 200,000 going in at day one and then it’s being invested for five years and then sold out, so all the possible iterations of those is 413 within that time horizon from 1976 to 2017.
Dr. Katherine Hunt: [08:11] That’s the general methodology that we followed and we tracked every single one of those portfolios across its investment time and measured where it was going.
Fraser Jack: [08:19] It sounds pretty reasonable from everything you’ve said just then, what might be considered to be, I don’t know if you could use the word average, but a fairly standard gearing portfolio. Five years was it? How did they come up with that number?
Dr. Katherine Hunt: [08:38] Yeah, we discussed that with one of the funders of this research, [Tupikoffs 00:08:42], a firm in Brisbane, and that five year time horizon was the benchmark that we were applying.
Fraser Jack: [08:50] Okay.
Dr. Katherine Hunt: [08:51] So we could potentially redo it with a 10 year or even a 20 year time horizon, but what we found when discussing these parameters is that things do change within five years, so although we like to think that we set up investments in growth assets for seven to 10 years minimum, in reality, especially with geared portfolios when we’re talking about approaching retirement, it is likely that there’ll be a review within that period of time as well. So we didn’t go with that ideal long, long, long term portfolio.
Fraser Jack: [09:26] Yeah, so a lot of work then, a lot of numbers and a lot of spreadsheets I imagine, going into this?
Dr. Katherine Hunt: 09:31 Mm-hmm (affirmative) awful.
Fraser Jack: [09:34] Tell us about what some of the things that you were expecting to come out of this and you either proved it or what surprised you.
Dr. Katherine Hunt: [09:44] What I expected was the kind of term that I’d heard when I was an advisor, which is; that gearing magnifies the returns but it also magnifies the losses. I was expecting that, so quite a polarized portfolio of return ... polarized return portfolio from these possible assets. What we actually found those was it’s kind of a little bit worse than that, across these portfolios anyway. What we did was of course we tracked the geared portfolios based on those parameters, we also tracked though identical portfolios, although with an initial investment just of the 100,000 capital that that investor would have had, invested over the same period of time, so another 413 non-geared portfolios of just 100,000 rather than the 200,000 geared.
Dr. Katherine Hunt: [10:40] And basically what we found; the average market portfolio was 141,000, the average geared portfolio was 218,000 at the end which means, effectively, 118,000, 3.4% return over five years not ... and that’s the average average and we’re talk across hundreds of portfolios. But we, of course, we do see a little bit of that magnification of the returns, so the maximum geared portfolio was a 35% return of 660,000 final balance so 560 take home.
Fraser Jack: [11:25] Are you saying 3.4% more than non-geared or just 3.4-
Dr. Katherine Hunt: [11:28] No, 3.4% was the-
Fraser Jack: [11:31] Average return?
Dr. Katherine Hunt: [11:33] The average return for a geared portfolio. Yeah. When the market return is obviously much higher than that, as we all know.
Fraser Jack: [11:42] So you found that geared portfolios return less than the market.
Dr. Katherine Hunt: [11:48] Mm-hmm (affirmative) yep.
Fraser Jack: [11:50] Wow.
Dr. Katherine Hunt: [11:52] Yep. And so some of the reasons for that, if we go through some of the other numbers that we see, is you do have the magnification of returns, the maximum geared portfolio; 660,000. The minimum was 51,000, huge loss, huge and a huge difference between those two. What we found is that only 54% of geared portfolios have a positive return over the five years and the ... 54% that’s; you’re flipping a coin. Is this portfolio going to work for me? Well, flip a coin to even be positive, to even beat inflation. And some of the reasons for that is, the bank, the lender, whoever it is; always gets paid first. The average interest paid by the geared portfolios was $46,000 over five years, that was just the average and the average MER was 15,000 over the five years.
Dr. Katherine Hunt: [12:58] You can see that the facilitators, the institutions, they’re getting paid first and then in order to actually get those returns that you’re thinking about, magnifying those returns, you need to first jump over that cost hurdle. That’s one of the reasons.
Dr. Katherine Hunt: [13:18] What we also found is there’s ... We already discussed before a little bit about that increase in investment risk, so there was a 48% higher volatility in the geared portfolios than the ungeared portfolios. And we know that, in theory, with volatility comes the potential for long term returns, but in this case because of that cost hurdle and the Sequencing Risk that I mentioned before it’s just not working out in a majority of these portfolios. And so the Sequencing Risk, I mentioned it before in terms of retirement and the issue that many advisors struggle with is that a client comes up for ... within a few years of retirement and something’s happening within their individual portfolio and they might not actually be in a good position to sell down and move into cash, but if they need the income then that’s possibly what’s going to be happening.
Dr. Katherine Hunt: [14:18] But what we found here is that the Sequencing Risk was really introduced at the start. The returns from the first 12 months of this five year portfolio completely predicted the returns at the end, completely. That means that Sequencing Risk at the start where you’re chucking 200,000 into the market at a point in time when you have no idea what’s going to happen in the future and if you get slammed immediately, well immediately, within the first 20% of your investment horizon, it’s very difficult. In fact this research seems to show that it’s extremely difficult to claw back from those losses.
Fraser Jack: [14:56] So that initial point when you’re putting money in if markets are low and, let’s say, providing value to get in, that’s the time? Is that what the ratios are showing? I’m assuming so.
Dr. Katherine Hunt: [15:09] Yes, in theory, but in practice we came up ... we made all these heat maps of when was a good time to go in. So when I’m looking at the heat map there’s a big chunk of time in 1982 and 1983 and then there’s a ... most of 2002 and that’s it.
Fraser Jack: [15:32] That’s it?
Dr. Katherine Hunt: [15:35] The rest, there’s no more other months in a row. So of course there’s like January 1993, okay fine. Who’s going to think in January 1983, “Now is the time! I know exactly what’s happening in the future and I know ...” Timing the market is a very complication being.
Fraser Jack: [15:56] Yes, yes it is and hindsight’s a wonderful thing.
Dr. Katherine Hunt: [16:00[ Mm-hmm (affirmative) the wisdom of hindsight. Indeed, indeed. So that’s for the geared portfolios, but for the non-geared portfolios there’s a lot of green in the heat map of when to go in. Yeah, you’ve also got 1997 and 1998 as well as 2003, 2004, there’s a bit of 2009 as well and all of 1976 and 1977 so there’s a lot more potential good times to go in. But that anticipating what the future looks like is a very complicated thing and, well, this research shows anyway that it can be done 20% of the time because 20% of those portfolios, the geared portfolios, were outperforming the market portfolios but only 20% of them.
Fraser Jack: [16:51] Okay, so it’s taking that Sequencing Risk on top of the volatility risk has just really, really hurt it?
Dr. Katherine Hunt: [16:59] Mm-hmm (affirmative) mm-hmm (affirmative) yep, especially at the ... with those initial investment losses. It really does sem to illustrate, the findings that we published and we wrote about, was really that gearing should be for sophisticated investment ... investors, potentially for people who are actively managing the portfolio rather than just, “Okay, I’m putting this in for five years.” And of course with a small percentage of overall assets just in case. But I think also maybe it does lend itself towards saying a strategy like Dollar Cost Averaging might have it’s merits as well, but we didn’t look at that in particular.
Fraser Jack: [17:42] Okay, now just because of course there’s a lot of geared investments and that’s been declining, as you mention, but there’s still a lot of leveraged investments that are out there, is this the same for both, you’ve found?
Dr. Katherine Hunt: [17:57] No. Well, this is gearing within the parameters that we’ve talked about, so leveraging in general, debt in general, other research that I do on the other side, on the financial inclusion side, has found that small and micro enterprises are the most efficient users of capital. They can take any amount, like any tiny amount of debt and turn it into huge returns, 1000s of percent and that’s common across small and micro businesses. That is what they do; they use capital most efficiently in our economy. If we’re talking about that is the most actively managed possible capital isn’t it? “What am I going to do with this money in my business right now today?” So there is a huge spectrum, this is obviously looking at that extreme spectrum of retail gearing.
Fraser Jack: [18:53] Yep, yep, sounds like that where they can waste a bit of money in these things. But I’m really interested too that you mention that the lender ... the lenders are making decent amount of money off the interest, obviously, and the [inaudible 00:19:10] ratio and those sort of things and they get paid 100% of the time when the consumers ending up with a benefit 54% of the time.
Dr. Katherine Hunt: [19:21] Yeah, so if we look at the worst 20% of those portfolios, as an example, the average portfolio end value is $128,000 out of starting with 200, and the average MER that’s paid is 12,000 and the average bank interest is 56. So $68,000 plus your 128 and you’re almost back up to square one but with that ... And it happens every time, and unless there is complete market collapse the lender doesn’t actually share the capital risk, they’re always going to get theirs back and we haven’t had complete market collapse and I hope it never comes.
Fraser Jack: [20:02] No, that’s right. But so it’s putting all of the onus on the investor who’s getting the worst returns out of all this, compared to say the lender or the institution?
Dr. Katherine Hunt: [20:15] Mm-hmm (affirmative)
Fraser Jack: [20:16] Wow. Okay, so that’s three sort of main things, three main take aways then there, isn’t there? The fact that the institution always is going to be okay and there’s a huge amount of volatility, obviously, and there’s a huge amount of Sequencing Risk.
Dr. Katherine Hunt: [20:33] Mm-hmm (affirmative) mm-hmm (affirmative)
Fraser Jack: [20:34] Okay, very good. And timeframes wise; I don’t know if that five years is, like you just said, it’s the five years of the thing that to be wondering ... I’m always interested in these sort of things and say, “Well, what else? What’s the next sort of step from here?”
Dr. Katherine Hunt: [20:51] Yes, absolutely. Well, what we could do is put the call out; whoever wants to fund this research to go to looking at a 10 year or a 20 year, pick a year, I don’t mind, timeframe; it can be done, can and will be done.
Fraser Jack: [21:05] Yeah, that’s really interesting, okay. All right, and obviously because gearing is the other thing to look at possibly on the back of this, as this is gearing investments, but housing of course is gearing as well, borrowing money and purchasing property, anything around that?
Dr. Katherine Hunt: [21:21] Everything I’ve done in that space is extremely supportive of debt for home purchasers in general and also debt for other necessities as well as housing. For example on the business side, what we found is that people actually aren’t very good at saving their way to wealth, but they are quite good at paying off a loan towards wealth. So yeah, in general, it does seem that debt can be a useful tool for many investors.
Fraser Jack: [21:54] Yeah, it seems to me that the fear of not paying the bank back is enough to make people have that regular saving content.
Dr. Katherine Hunt: [22:01] Yeah, yeah, it’s amazing and even especially in Australia we have a culture where people will pay their mortgage before other vital things like food.
Fraser Jack: [22:10] Yeah, fair enough. The banks have done well there to instill fear.
Dr. Katherine Hunt: [22:15] They have done very well.
Fraser Jack: [22:17] All right, great, so if somebody wants to check out this research or have a little bit more of it; how can they get hold of it or go through?
Dr. Katherine Hunt: [22:24] It’s published in the Australian Journal of Applied Finance, it’s the 2018 issue one, possibly ... Yeah, issue one. In theory it can be accessed online and if anyone has any difficulty with that they can just email me at firstname.lastname@example.org and I can just email you the full paper which has a lot of pretty pictures in it, all those heat maps that I was talking about and all the tables with detail about who’s really losing out on this and how in this, I say losing out, in this simulated research that we’ve done.
Fraser Jack: [23:04] Sounds fantastic, all right, thank you Katherine for coming on and sharing that research. If anyone wants a copy of that; get hold of Katherine and if anybody wants to sponsor the next research then also contact Katherine I guess.
Dr. Katherine Hunt: [23:18] Fantastic, thanks so much, Fraser.
Fraser Jack: [23:20] Thanks, Katherine.
Fraser Jack: [23:22] If you haven’t already I’d love you to subscribe to the podcast on your podcast platform of choice and to continue the conversation head over to our social media channels. We’ll catch you next time.
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